Depositor preference, bank resolution costs, and encumbrance
Daniel C. Hardy
International Monetary Fund and Austrian Financial Markets Authority[1]
“Bankruptcy is a situation in which existing claims are inconsistent” (Hart, 1995)
Objectives
The recent global financial crisis and in particular the collapse of Lehman Brothers has provided many reminders of how complex and expensive it can be to resolve a bank. The proposed policy responses involve the reform of crisis management and resolution tools, including more generous depositor guarantees and associated depositor preference in bank resolution (the U.S. has had depositor preference for two decades; the U.K. is considering its introduction). Yet, any change in the bank resolution framework will have implications for bank funding costs, and needs to take into account reactions by others. For example, better protection of depositors may lead to preemptive moves by others to secure their claims, thus encumbering banks’ balance sheets further (Haldane, 2012). The paper will investigate the implications of depositor preference for bank financing and possible welfare effects.
Method
The literature on bankruptcy procedures and financial structure (e.g., Berglöf et at, 2010, and Hart, 1995) provides a starting point for addressing the issues that arise. In adapting this literature, it is important to recognize that bank resolution costs are not set just by institutional features, but in part reflect a kind of “war of attrition” between claimants.
Expected Results
It will be shown that depositor preference can forestall such a costly conflict by pre-assigning control rights when contracts are incomplete (Bolton and Faure-Grimaud, 2009). There is a net benefit because depositor preference determines who will get the bulk of a failed bank’s assets, which can then more easily be sold to another institution. The distribution of the benefit will be investigated; in some circumstances, the main beneficiaries may be otherwise uninsured depositors, rather than the deposit guarantee scheme.
In response to depositor preference, non-preferred creditors are likely to collateralize more of their claims, but rising marginal costs of doing so will limit the race to security. The net costs of such collateralization relative to the benefits of reduced resolution costs, and the effects on the distribution of net costs, will be investigated.
The model will be extended to a discussion of why specifically depositors are suitable for receiving such preference, in terms of relative ability to fight a “war of attrition,” depositors’ risk sensitivity, and the magnitude of bank losses that need to be allocated. A further extension would incorporate unforeseen funding needs that cannot be met by raising deposits. For the sake of tractability, however, it will be necessary to abstract from various complications, such as the possibility of strategic default.
[1] The views expressed are those of the author only.